Barclays analysts said in a note Tuesday that an “unprecedented rotation” in the stock market, driven by higher hopes for US rate cuts, “should stop very soon.”
This rotation has seen a significant shift into small-cap firms, resulting in a remarkable rally in small caps, which has surpassed all other indices with a 3.5 times weekly standard deviation rally.
This shift has included a “Big Tech unwind, NDX to RTY flows, momentum reversal, and SPW/SPX broadening.”
According to Barclays, small-cap firms, with their more levered balance sheets and floating rate debt, are more sensitive to interest rates than at any point in the last decade.
Currently, “small cap vol to S&P vol is near a 20-year peak,” notes Barclays, emphasizing the heightened volatility in this sector. This movement is largely attributed to a “positioning-driven technical squeeze,” supported by a “strongest spot up/vol up dynamic in decades and much higher call to put volumes.”
Despite the recent surge, Barclays believes that small caps, which have nearly closed their historical discount to large caps, possess weaker fundamentals. The bank says they have deteriorating leverage profiles and lower forward EPS expectations, making the recent rotation unsustainable.
Barclays is skeptical about street forecasts predicting a strong margin pick-up for small caps in the second half of the year relative to large caps. Consequently, Barclays analysts suggest that this rotation “has largely run its course and do not expect it to continue this week.”
Barclays adds that the US economy remains stable, with Q2 GDP surpassing expectations at 2.8% q/q saar. However, they note concerns persist regarding the global economy, with Euro area PMIs and China’s Q2 data missing forecasts. Despite this, the resilience of US economic data suggests that the recent USD weakness is unlikely to persist.